What Does "Due Diligence" Mean? A Beginners Guide - Article

What Does "DD" Mean When Investing in Stocks?

First things first, "DD" stands for "Due Diligence". Sometimes when discussing an investment with others, investors will also write or say "DYOD", which stands for "Do Your Own Diligence."

It's a fancy way of saying that you're doing your homework on a potential investment. Just like you wouldn't buy a car without checking under the hood and taking it for a test drive, you shouldn't invest your hard-earned money in a stock without researching the company first.

Now, you might have seen people talking about "DD" on Reddit's Wall Street Bets or other financial sites. It's a pretty popular term, and for good reason. Doing your due diligence properly can help you make smarter investment decisions and avoid losing money on bad stocks.

So, what exactly should you look at when you're doing your DD?

Here are the key things to pay attention to:

Company Market Capitalization (Mkt Cap): This is the total value of the company, calculated by multiplying the number of shares by the current stock price. For example, if a company has 1 million shares outstanding and the stock price is $10, the market cap would be $10 million. Generally, larger companies (like Apple or Amazon) have higher market caps, while smaller companies have lower market caps.‍
Revenue & Profit Margin Trends: Revenue is the total amount of money a company makes from selling its products or services. Profit margin is the amount of money a company keeps after paying all its expenses. You want to look for companies with growing revenue and healthy profit margins. For example, if a company's revenue has been increasing by 20% every year and its profit margin is 25%, that's a good sign.‍
Competitors & Industries: No company exists in a vacuum. It's important to understand who a company's competitors are and what the overall industry looks like. Is the industry growing or shrinking? Are there any major trends or disruptions happening? For example, if you're looking at a company that makes smartphones, you'd want to consider competitors like Apple and Samsung, as well as trends like the rise of 5G networks.‍
Valuation: This is where you try to figure out if a stock is undervalued (a good deal) or overvalued (too expensive). One common metric is the price-to-earnings ratio (P/E ratio), which compares a company's stock price to its earnings per share. A high P/E ratio could mean the stock is overvalued, while a low P/E ratio could mean it's undervalued. But be careful - a low P/E ratio could also be a red flag that something's wrong with the company.‍
Management and Ownership: Who's running the company? Do they have a good track record? Are they aligned with shareholders' interests? You can find this info in the company's annual reports and proxy statements. For example, if the CEO owns a lot of the company's stock, that's usually a good sign that they're motivated to help the stock price go up.‍
Financial Health: This is where you look at a company's balance sheet to see how much cash and debt they have. Too much debt can be a red flag, while a lot of cash can be a good sign. You'll also want to look at things like free cash flow (the amount of cash a company generates after paying for capital expenses) and working capital (the difference between a company's current assets and current liabilities).‍
Stock Price History: Has the stock been going up or down lately? Is it volatile or stable? While past performance doesn't guarantee future results, looking at a stock's price history can give you some context. For example, if a stock has been consistently going up for the past few years, that could be a sign of a strong company. But if it's been bouncing up and down like crazy, that could be a red flag.‍
Stock Options & Dilution: Some companies issue stock options to their employees as a form of compensation. While this can be a good way to attract and retain talent, it can also lead to dilution (when a company issues new shares, reducing the value of existing shares). You'll want to keep an eye on how many stock options a company has outstanding and how that could impact the stock price.‍
Expectations & Analyst Estimates: What do professional analysts think about the stock? Are they bullish (expecting the price to go up) or bearish (expecting it to go down)? You can find analyst reports on financial news sites like Yahoo Finance, www.analystsnotes.com or Morningstar. But remember - analysts can be wrong, so don't just blindly follow their advice.‍
Risks & Weaknesses: No company is perfect. As part of your DD, you'll want to consider what could go wrong with the stock. Is the company heavily dependent on one customer or product? Are they facing any legal or regulatory issues? Is there a lot of competition in their industry? Thinking about these risks can help you make a more informed decision.

Phew, that was a lot of info! But don't worry - you don't have to become an expert in every single aspect of a company before investing. The key is to do enough research to feel confident in your decision. And if something doesn't make sense or seems too good to be true, trust your gut and keep digging.

At the end of the day, DD is all about being an informed investor and keeping your money safe. By taking the time to understand a company's strengths, weaknesses, and potential risks, you'll be better equipped to make smart investment decisions and build a strong portfolio over time. Build up your knowledge over time. And don't invest in things that you do not understand.

How to conduct due diligence for a stock

Ready to dive into the world of due diligence? Don't worry, we've got your back. Let's break down how to properly research a company before investing your hard-earned cash.

1. Market Capitalisation

First things first, let's talk about market capitalization, or "market cap" for short. This is a key metric that tells you how big a company is. To calculate it, you simply multiply the current share price by the total number of shares outstanding. For example, if a company has 1 million shares and the stock price is $10, the market cap would be $10 million (1 million x $10).

Now, why does market cap matter? Well, it gives you a sense of the company's size and reach. Take Amazon, for example. With a market cap of $1.89 trillion, it's one of the biggest companies in the world, with a massive global presence. On the flip side, a small regional hotel chain would have a much lower market cap and limited reach.

In general, larger companies (think Apple, Microsoft, or Johnson & Johnson) tend to be less volatile. They usually have more consistent revenue streams and are less likely to be affected by short-term market fluctuations. These are often called "blue-chip" stocks.

Smaller companies, on the other hand, can be more of a wild ride. They tend to be more volatile, meaning their stock prices can swing up or down more dramatically. But with higher risk can come higher reward. These small-cap stocks, like junior mining companies or biotech startups, can potentially offer bigger returns if they strike gold (literally or figuratively).

So, how can you check a company's market cap? Easy! Most stock brokers will list the market cap for each stock but if you are just looking for a daily figure, Google will do. Just type in the company's name or ticker symbol, and voila!

What Does "Due Diligence" Mean? A Beginners Guide - Article | Crux Investor (1)

But market cap is just one piece of the puzzle. Here are a few other key things to look at when doing your due diligence:

Revenue and profit trends: Is the company's revenue growing or shrinking? Are they consistently profitable, or do they have a history of losses? You can find this info in the company's financial statements.
Debt levels: How much debt does the company have compared to its assets and earnings? Too much debt can be a red flag.
Industry trends: What's going on in the company's industry? Are there any major shifts or disruptions happening? For example, the rise of streaming services like Netflix has disrupted the traditional cable TV industry.
Valuation: Is the company's stock price reasonable based on its earnings and growth potential? Common valuation metrics include the price-to-earnings ratio (P/E ratio) and price-to-sales ratio (P/S ratio).
Management team: Who's running the show? Look for experienced leaders with a track record of success. You can find info on the company's management team in its annual reports and on its website.

Remember, due diligence is all about being an informed investor. Don't just buy a stock because some dude on Reddit told you to. Take the time to understand the company's business, financials, and potential risks. And if something seems too good to be true, it probably is.

But hey, don't let all this research scare you off. Investing can be a great way to grow your wealth over time. Just start small, diversify your portfolio, and always stay curious.

2. Examine Revenue and Profit Margin Trends

Let's talk about 2 more key things to look at when researching a stock: revenue and profit margins.

First up is revenue. This is the total amount of money a company brings in from selling its products or services. It's the top line of the company's income statement. For example, if Apple sells 100 million iPhones at $1,000 each, their revenue would be $100 billion (100 million x $1,000).

But revenue doesn't tell the whole story. That's where profit margins come in. Profit margin is the percentage of revenue that a company keeps as profit after paying all its expenses (like salaries, rent, and raw materials). It's calculated by dividing net income (profit) by revenue.

Let's say Apple's expenses for making and selling those iPhones were $80 billion. Their net income would be $20 billion ($100 billion revenue - $80 billion expenses). To calculate the profit margin, we divide the net income by the revenue: $20 billion / $100 billion = 0.2, or 20%.

Now, why do revenue and profit margins matter? Well, they give you a sense of how the company is performing over time. When you're researching a stock, it's a good idea to look at the revenue and profit margin trends for the past few years. You can find this info in the company's earnings reports, which they release every quarter.

Here's what to look for:

Consistency: Has the company's revenue been growing steadily, or is it all over the place? Consistent growth is a good sign, while erratic ups and downs could be a red flag.
Growth: Is the company's revenue increasing year over year? If so, that's a positive sign. But if revenue is flatlining or declining, that could indicate trouble.
Profitability: Is the company consistently profitable, or does it have a history of losses? A company that's consistently in the red might not be a great investment.
Margin trends: Are the company's profit margins increasing, decreasing, or staying the same? Increasing margins could mean the company is becoming more efficient, while decreasing margins could signal increased competition or rising costs.

Let's look at a real-world example. Tesla, the electric car company, has seen massive revenue growth over the past few years. In 2023, their revenue was $96.77 billion, up from $81.46 billion in 2022 and $53.8 billion in 2021. That's impressive growth!

In 2023, their net income was $15 billion, giving them a profit margin of 15.5% ($15 million / $96.77 billion). In 2022, they had a net income of $12.58 billion, and a profit margin of 14.95%. Net income in 2021 was $5.5 billion...their profit margin for 2021 was 10.26%! remarkable growth, but off of a low base because of the supply chain issues globally in 2020 and 2021. Revenue growth looks great now though. It's important to look at both revenue and profit margins to get a more complete picture of a company's financial health.

Finally, revenue and profit margins are used to calculate some key valuation metrics, like the price-to-sales ratio (P/S) and price-to-earnings ratio (P/E). These ratios compare a company's stock price to its sales or earnings, helping you determine if the stock is undervalued or overvalued. We'll dive into valuation more later, but for now, just remember that revenue and profit margins are the building blocks for these important metrics.

So, when you're researching a stock, don't just focus on the current revenue and profit numbers. Look at the trends over time, and try to understand what's driving those trends. Is the company gaining market share? Are they launching new products? Are costs going up? The more you understand about a company's financial performance, the better equipped you'll be to make smart investment decisions.

3. Explore Competitors & Industries

Let's dive into another important aspect of researching a stock: checking out the company's competitors and industry

First off, why does this even matter? Well, imagine you're considering investing in a company that makes smartphones. It might seem like a great investment opportunity - after all, everyone uses smartphones these days, right? But what if you found out that this company only has a tiny market share compared to giants like Apple and Samsung? Suddenly, it doesn't seem like such a sure bet.

That's why it's crucial to look at a company's competitors. Even if a company has a great product or service, it could still struggle if it's up against tough competition. On the flip side, a company that's dominating its industry and crushing its competitors could be a very attractive investment opportunity.

So, how do you research a company's competitors? Start by looking at the company's annual report or website. They'll often mention their main competitors there. You can also search for news articles about the company and its industry to see who else is making waves.

Once you've identified the main competitors, it's time to do some comparisons. Here are a few key things to look at:

Market share: What percentage of the total market does each company control? Is your company gaining or losing market share over time?
Revenue and profit margins: How do the companies stack up in terms of revenue and profitability? If your company has much lower margins than its competitors, that could be a red flag.
Valuation: How does the market value each company? You can use ratios like the price-to-earnings (P/E) ratio or price-to-sales (P/S) ratio to compare valuations. If your company has a much higher P/E ratio than its competitors, it could be overvalued.
Growth rates: Which companies are growing their revenue and profits the fastest? A company that's growing quickly could be a better investment than one that's stagnating, even if it's smaller.

Let's look at an example. Say you're considering investing in Lyft, the ride-sharing company. Lyft's main competitor is obviously Uber. So, you'd want to compare market share, revenue, profit margins, valuation, and growth rates between the two companies.

As of 2022, Uber controls about 74% of the U.S. ride-sharing market, while Lyft has about 26%. Uber also has higher revenue and is growing faster than Lyft. However, neither company is consistently profitable yet, and both have faced challenges during the 2020/21 pandemic as demand for ride-sharing dropped.

4. Check valuation multiples

Valuation refers to how fairly a company is valued, based on its financial performance compared to its market value.

Let's talk about a super important part of researching a stock: valuation. This might sound like a fancy term, but don't worry - we'll break it down.

Valuation basically means figuring out if a company's stock price is fair based on its financial performance. Think of it like this: if you were buying a used car, you'd want to know if the price was fair based on the car's condition, mileage, and features, right? It's the same idea with stocks.

Now, there are a few different ways to measure valuation. Don't get overwhelmed by the acronyms - we'll explain each one - and each one for most publicly listed companies can be viewed on a stock screener, like Tradingview's, for free.

What Does "Due Diligence" Mean? A Beginners Guide - Article | Crux Investor (2)

Price-to-earnings ratio, or P/E ratio

This is probably the most common valuation metric. To calculate it, you take the current stock price and divide it by the company's earnings per share (EPS). EPS is just the company's total profit divided by the number of shares.

For example, let's say a company's stock is trading at $50 per share, and its EPS for the last year was $5. The P/E ratio would be 10 ($50 / $5). This means investors are willing to pay $10 for every $1 of the company's earnings.

P/E ratios can vary a lot by industry. Tech companies often have high P/E ratios (sometimes over 100!), while more established companies like utilities or banks tend to have lower P/E ratios (maybe 10-20). A high P/E ratio could mean investors expect the company to grow quickly, while a low P/E ratio could mean the stock is undervalued.

Price-to-sales ratio, or P/S ratio

This is similar to the P/E ratio, but instead of using earnings, it uses the company's total sales (revenue). To calculate it, divide the stock price by the company's sales per share.

P/S ratios can be useful for companies that aren't profitable yet. For example, many young biotech companies are investing heavily in research and development, so they might not have positive earnings. But if they have strong sales growth, the P/S ratio can give you a sense of how the market values them.

Price/earnings-to-growth or PEG ratio

This takes the P/E ratio and divides it by the company's expected earnings growth rate. It's a way to compare companies that are growing at different speeds.

For instance, let's compare two companies: Company A has a P/E ratio of 20 and is expected to grow earnings by 10% per year. Company B has a P/E ratio of 40 but is expected to grow earnings by 30% per year. Company A's PEG ratio would be 2 (20 / 10), while Company B's would be 1.33 (40 / 30). Even though Company B has a higher P/E ratio, its faster growth rate makes it look like a better value based on the PEG ratio.

Price-to-book ratio, or P/B ratio

This compares a company's market value to its book value (the value of all its assets minus liabilities). It's often used for companies with lots of physical assets, like banks, real estate firms, or manufacturers. To calculate the P/B ratio, divide the company's market cap (total value of all shares) by its book value. A ratio below 1 could mean the stock is undervalued, while a high ratio could mean it's overvalued.

So, why do all these ratios matter? Well, they help you compare companies on an apples-to-apples basis. If you're looking at two companies in the same industry, the one with lower valuation ratios might be the better bargain.

But remember, valuation is just one piece of the puzzle. A stock with a low P/E ratio might be cheap for a reason - maybe the company is facing challenges or has poor management. On the flip side, a stock with a high P/E ratio might be pricey but could have amazing growth potential. The key is to use valuation ratios as a starting point, not the be-all-end-all. Always look at the bigger picture, including the company's competitive position, financial health, and future prospects.

And don't be afraid to compare a company's valuation to its industry peers. If every stock in the industry has a P/E ratio around 20, but the one you're looking at has a P/E of 50, that could be a red flag.

In summary, valuation is a key tool in your stock research toolkit. By understanding ratios like P/E, P/S, PEG, and P/B, you can get a sense of whether a stock is fairly priced relative to its earnings, sales, growth, and assets. Use these ratios to compare companies, but always remember to look at the broader context.

5. Examine ownership and management structure

Let's now look at 2 more crucial factors to consider when researching a stock: ownership and management structure. Trust me, this stuff might not seem as exciting as watching the stock price bounce around, but it can make a huge difference in your investment decision

Management Team

These are the bigwigs running the show - the CEO (Chief Executive Officer), CFO (Chief Financial Officer), and other Executives. You want to make sure these folks know what they're doing and have a track record of success. Think of it like a sports team. If you're betting on a team to win the championship, you'd want to know that the coach and star players have experience and a history of winning, right? It's the same with a company's management team.

Annual Report

So, how can you tell if a company's management is up to it? One great resource is the company's annual report. This is a document that publicly traded companies are required to release every year, and it's chock-full of juicy details.

In the annual report, look for the section that introduces the management team. It should give you a rundown of each executive's background, including their education, previous jobs, and how long they've been with the company. If you see a bunch of execs with decades of experience in the industry and a history of leadership roles, that's a good sign. But make sure they have a track record of success. And by success, we mean, 'have they made money for shareholders before' This is one instance where a 'taking-part medal' isn't enough.

If the management team is full of newbies or folks who have bounced around a lot without much success, that could be a red flag. You want to see stability and a proven track record.

Ownership Structure

This refers to who actually owns the company's stock. Is it mostly owned by individual investors like you and me? Or are there big institutional investors involved, like hedge funds or pension funds?

One particularly interesting thing to look at is insider ownership. This means the amount of stock owned by the company's executives and directors. If the bigwigs have a lot of skin in the game, that could be a good sign. It means they have a vested interest in the company's success. For example, let's say you're considering investing in 2 different equally sized and valued tech companies. Company A's CEO owns 20% of the total shares, while Company B's CEO only owns 1%. All else being equal, Company A's CEO is probably going to be more motivated to drive the company's success, since their personal wealth is tied to the stock price.

You can usually find information on insider ownership in the company's proxy statement, which is another annual filing. Look for a table that shows how many shares each executive and director owns. But insider ownership isn't always a slam dunk. If you see executives suddenly dumping a bunch of their shares, that could be a bad sign. It might mean they know something about the company's future prospects that the rest of us don't. Likewise, is the management team buying shares in the open market when they have an opportunity to do so? If not, why not? So, keep an eye on those insider transactions!

To sum it up, when you're researching a stock, don't just focus on the numbers. Take a close look at who's running the show and who owns the company. A strong, experienced management team and high insider ownership can be great indicators of a company's potential.

Of course, this is just one piece of the puzzle. You'll also want to dig into the company's financials, competitive position, and growth prospects. However, understanding management and ownership is a key part of due diligence. So, next time you're considering a stock, take a few minutes to check out the annual report and proxy statement. See if the management team has the right stuff, and if the insiders are putting their money where their mouth is. It just might give you the insight you need to make a smart investment decision.

Remember - always do your own research! Don't just take some random person's word for it (even if that random person is me).

6. Examine Financial Health

Another crucial aspect of researching a stock: examining the company's financial health. We know, we know - the word "financial" might make your eyes glaze over. But trust me, this stuff is important if you want to make smart investment decisions.

Think of it like this: if you were considering dating someone, you'd probably want to know if they had a stable job, right? You wouldn't want to get involved with someone who was drowning in debt or could never seem to pay their bills on time. Well, it's the same idea with a company. Before you invest your hard-earned cash, you want to make sure the company is financially sound.

Balance Sheet

So, where do you start? The first place to look is the company's balance sheet. This is like a snapshot of the company's financial position at a given point in time. It shows you what the company owns (its assets), what it owes (its liabilities), and what's left over for the shareholders (equity).

Assets could include things like cash, inventory, equipment, and property. Liabilities could include things like loans, accounts payable (money owed to suppliers), and taxes owed. Equity is basically the difference between assets and liabilities - it's what would be left for shareholders if the company sold all its assets and paid off all its debts.

When you're looking at the balance sheet, you want to see a healthy mix of assets and liabilities. Too many liabilities could mean the company is struggling to pay its bills. Too few assets could mean the company doesn't have the resources it needs to grow and compete.

For example, let's say you're looking at the balance sheet for a small restaurant chain. You see that they have $1 million in cash, $500,000 worth of kitchen equipment, and $2 million in property (the restaurant buildings). On the liabilities side, you see $1 million in loans and $200,000 owed to food suppliers. In this case, the company has more assets than liabilities, which is a good sign. They have some debt, but they also have a decent cash cushion and valuable property.

Income Statement

But the balance sheet is just one piece of the financial puzzle. You'll also want to look at the company's income statement, which shows revenue (money coming in) and expenses (money going out) over a period of time, usually a quarter or a year.

On the income statement, pay attention to the company's revenue streams. Are they diversified, or does the company rely on just one or two main sources of income? Diversification is usually a good thing - it means the company isn't putting all its eggs in one basket.

For instance, let's say you're researching a company that makes sports equipment. If 90% of their revenue comes from selling footballs, that could be risky. What happens if there's a sudden drop in demand for footballs? But if the company sells footballs, basketballs, soccer balls, and yoga mats, they're more protected against shifts in any one market.

Expenses

You'll also want to look at the company's expenses and net income. Net income is basically revenue minus expenses - it's the company's profit. Ideally, you want to see positive net income and a trend of growing profits over time.

If a company consistently spends more than it brings in, that's a red flag. They might be borrowing money or selling assets just to stay afloat. On the other hand, if a company is consistently profitable and growing its earnings, that's a good sign.

Cash Flow

Finally, don't forget about cash flow. This shows how much actual cash is moving in and out of the company. Even if a company is profitable on paper, if they're not generating enough cash to pay their bills and invest in growth, that could spell trouble. You can find all these financial statements on the company's website, usually in the "investor relations" section. They might look intimidating at first, with all those numbers and accounting terms. But take your time, read through them carefully, and don't be afraid to look up terms you don't understand.

Remember, investing is a learning process. The more you dig into companies' financials, the better you'll get at spotting red flags and identifying opportunities. So, roll up your sleeves, grab a calculator (just kidding, spreadsheets are your friend), and start exploring those financial statements. Your future self (and future bank account) will thank you!

7. Consider the Stock Price History

Another piece of the stock research puzzle is the stock price history. It's tempting to just look at the current price and call it a day. But trust me, taking a deeper dive into how the stock has performed over time can give you some valuable insights.

First off, let's talk about what we mean by "stock price history." It's just a record of how the stock price has changed over time. You can find this info by Googling. They'll show you a chart of the stock price going back months, years, or even decades. Is the trend up or is the trend down?

Now, when you're looking at this chart, there are a few key things to keep an eye out for:

Volatility: Has the stock price been jumping all over the place, or has it been pretty steady? A stock that's super volatile (meaning the price swings up and down a lot) can be riskier than one that's more stable. It's like riding a rollercoaster versus a gentle train ride - the rollercoaster might be more thrilling, but it's also more likely to make you lose your lunch.
Trend: Is the stock price generally going up, down, or sideways over time? If it's been on a steady upward climb, that could be a good sign. But if it's been trending downward or just bouncing around with no clear direction, that might be a red flag.
Reaction to news: How does the stock price react to major news events, like earnings reports, product launches, or changes in leadership? If the stock tends to shoot up on good news and plummet on bad news, that could be a sign that it's more volatile and prone to big swings.

Let's look at an example. Say you're considering investing in 2 different companies: Company A and Company B. You pull up the stock price history for both companies over the past year.

For Company A, you see that the price has been pretty stable, hovering around $50 per share. There have been a few small dips and bumps along the way, but nothing too dramatic. Overall, it's been on a slight upward trend, going from $45 to $55 over the course of the year.

For Company B, on the other hand, it's a different story. The price has been all over the place, ranging from $20 to $80 per share. It seems to react strongly to every little bit of news - shooting up 20% one day, then crashing 30% the next. There's no clear trend - it's just a wild ride.

Based on this info, Company A might be the safer bet. Its stock price has been more predictable and less volatile. Company B, while it could potentially offer bigger rewards, also comes with a lot more risk.

But here's the thing: stock price history is just one small piece of the puzzle. It's important to look at, but it shouldn't be the only factor in your investment decisions.

Think of it like looking at someone's dating history. Sure, if they have a pattern of tumultuous, short-lived relationships, that might be a red flag. But just because someone has had a few stable, long-term relationships doesn't necessarily mean they're a great partner. You'd want to look at other factors too, like their personality, values, and how they treat you.

It's the same with stocks. A stock with a stable, upward-trending price history might still be a bad investment if the company has shaky financials, lousy management, or is in a dying industry. On the flip side, a stock with a more volatile price history could still be a good investment if the company has solid fundamentals and a bright future.

So, by all means, take a look at the stock price history. But don't get too hung up on it. Use it as one data point among many in your research process.

And remember, investing is a marathon, not a sprint. Just because a stock has had a good run lately doesn't mean it will keep going up forever. On the flip side, just because a stock has taken a dive doesn't mean it's doomed. Keep a long-term perspective, and don't let short-term price movements sway you too much.

At the end of the day, the key is to do your homework, stay diversified, and invest in companies you believe in for the long haul. And if all else fails, just remember: past performance is no guarantee of future results. But you're already starting to think like this aren't you?

8. Examine Stock Options & Dilution

We're going to talk about a topic that might sound a little complicated at first, but don't worry - we'll break it down into plain English. We're going to discuss stock options and dilution.

What the heck are stock options?

Essentially, they're a type of compensation that companies give to their employees. Instead of just giving them a regular paycheck, the company says, "Hey, we'll give you the right to buy a certain number of shares of our stock at a specific pre-agreed price, and you can do that at some point in the future."

It's essentially your boss giving you a piece of paper that says "Buy our company's stock for $50 a share anytime in the next 5 years, even if the stock price goes up to $100!" If the stock price does go up, you could buy the stock at the lower price and then immediately sell it at the higher price, pocketing the difference as profit. Pretty sweet deal, right?

Dilution

Now, here's where things can get a little tricky. Let's say a company gives out a ton of these stock options to its employees. If the stock price goes way up, a lot of those employees might decide to exercise their options and buy the stock. Suddenly, there are a lot more shares of the stock out there in the market. This is called dilution.

Think of it like pouring water into your favorite soft drink. The more water you add, the more diluted the drink gets. The same thing can happen with stocks. The more shares that get added to the pool, the more diluted the value of each individual share can become.

Here's an example: Let's say Company X has 1 million shares of stock outstanding, and the stock is trading at $100 per share. The company's market cap (the total value of all its shares) is $100 million. Now, let's say Company X has also given out stock options to its employees that would allow them to buy another 1 million shares at $50 per share. If the stock price goes up to $150 and all those employees exercise their options, suddenly there are 2 million shares outstanding instead of just 1 million.

Even though the company's value hasn't changed, each individual share is now worth less, because the value of the company is spread out over more shares. In this case, the stock price might drop closer to $75 (the new market cap of $150 million divided by 2 million shares).

Dilution can be a concern for investors, because it can mean that the value of their shares could drop, even if the company is doing well. That's why it's important to keep an eye on how many stock options a company has outstanding.

SEC Filings

So, where can you find this info? Companies are required to report this stuff in their quarterly SEC filings, which are called 10-K and 10-Q reports. You can usually find these on the company's website under the "Investor Relations" section. In these reports, look for information about "outstanding stock options," "stock compensation," or "diluted shares." This will give you an idea of how many extra shares could potentially be added to the pool through stock options.

Now, this doesn't mean you should automatically avoid companies with a lot of outstanding stock options. Many successful companies use stock options as a way to attract and retain top talent. But it is something to be aware of and to factor into your overall analysis of the company.

In summary: Stock options are a type of compensation that gives employees the right to buy company stock at a set price in the future. If a lot of employees exercise these options, it can lead to dilution, which means each share is worth less, even if the company's overall value hasn't changed. You can find information about a company's outstanding stock options in its quarterly SEC filings. While dilution is something to be aware of, it's just one piece of the puzzle when evaluating a potential investment.

9. Consider Market & Analyst Expectations

When you're thinking about investing in a stock, it's not just about looking at the company itself. You also want to take a peek at what other people are saying about it, especially the experts. This is where market and analyst expectations come into play.

What is an Analyst?

First off, let's talk about analysts, sometimes called Financial Analysts. These are the folks who get paid to study companies and make predictions about how they'll perform in the future. They're kind of like the weather forecasters of the stock market.

Analysts will look at things like how much revenue (money coming in) they think the company will make in the coming years, and how much earnings per share (EPS) the company will generate. EPS is basically how much profit the company makes for each share of stock. For example, let's say you're thinking about investing in a company that makes electric scooters. You look up some analyst reports and see that they're predicting the company will make $100 million in revenue next year, and have an EPS of $2. This means for every share of stock, the company is expected to make $2 in profit.

Analysts will also often give a price target for the stock. This is where they think the stock price will be in the future, usually a year from now. So if the stock is currently trading at $50 and the analyst has a price target of $75, they think the stock will go up by 50% over the next year.

Now, here's the thing about analysts: they're not always right. In fact, they can be wrong a lot of the time. That's why you don't want to just blindly follow what they say. But it's still good to know what they're thinking, because it can give you an idea of what the general expectations are for the company. It's also important to look at the credibility of the analysts. Have they been accurate in the past? Or are they incentivised to talk the company up and by so doing mislead potential shareholders? Some banks give favourable reviews of a company as they hope the company will use them for future fundraisings. In this instance, the bank will charge the company a fee for the raise and in doing so make money from having talked the company up.

Another thing to look at is the overall mood in the financial media and on social media. Are people generally excited about the company, or are there a lot of negative stories? Is the company getting a lot of buzz, or is it flying under the radar? For example, let's say you're scrolling through Twitter and you start seeing a lot of tweets about how this electric scooter company is the next big thing. Everyone's talking about how they're going to revolutionize transportation and take over the world. That's a sign that there's a lot of hype and excitement around the company.

On the other hand, if you're seeing a lot of news stories about how the company is facing lawsuits, or there are concerns about the safety of their scooters, that's a red flag. It suggests that there's some negative sentiment around the company.

Sentiment and Momentum

Now, just like with analysts, you don't want to make investment decisions solely based on media buzz or social media chatter. Sometimes hype can be overblown, and sometimes negative stories can be overblown too. But it's still good to have a pulse on what people are saying as it tells you what the market sentiment is.

So, how do you find all this information? For analyst expectations, you can look at financial websites like Yahoo Finance or Morningstar. They'll often have a section that shows analyst ratings, price targets, and revenue/EPS projections. For media sentiment, just start Googling the company and see what kind of stories come up. Are they mostly positive, negative, or neutral? You can also check out financial news sites like CNBC or Bloomberg to see what they're saying. And for social media buzz, try searching for the company on X/Twitter or Reddit. See what kind of conversations are happening. Are people excited about the company, or are there a lot of complaints and concerns?

Also, be conscious that most chatrooms and social media tend to attract very 'loud' commentators. Being loud doesn't make them correct and often they are heavily invested in the stock or incentivised to pump up the stock or attack it. Question every statement made and do not take it as fact until you have verified it. If you do so, you will be part of the silent majority who choose not to engage or get misled by the lunatic fringes where fact and fiction are intertwined.

Remember, all of this is just one piece of the puzzle. You don't want to base your entire investment decision on what analysts or the media are saying. But it's good to have that context and to understand what the general expectations and sentiments are around the company.

At the end of the day, the most important thing is to do your own research and come to your own conclusions. Be honest, really honest, with yourself about what you think. Do you like it? Stop looking at the guy beside you to make your financial decisions for you. Chances are he doesn't care if you lose your money. Look at the company's financials, understand its business model and competitive landscape, and think about whether you believe in its long-term potential. Analyst expectations and media buzz can be informative, but they shouldn't be the be-all and end-all of your investment decisions.

Look at what the experts are saying, but always remember to think for yourself. And if all else fails, just remember: never invest more than you can afford to lose, and always diversify your portfolio.

There are more companies looking for more money than exists, so there will be another better investment just around the corner. Do not be in a rush to invest your money, That's how you will lose it. You are here to make money, so think hard before you give it to someone else. ‍

10. Explore Risks & Weaknesses

This is not always the most fun part of researching a stock, but it's super important, possibly the most important thing: looking at the risks and weaknesses.

No company is perfect, and every investment comes with some level of risk. Your job as an investor is to understand what those risks are and decide if you're comfortable with them. These are the kinds of risks which lose you all your money. So pay attention and don't be casual about your decision-making.

Types of Risk

First, let's talk about the different types of risks. There are risks that are specific to the company itself, risks that apply to the whole industry the company is in, and risks that come with the stock market in general.

Company-specific risks could be things like:

Competition: Is there another company out there that could swoop in and steal market share? For example, if you're looking at investing in a small streaming service, you'd want to think about how they stack up against giants like Netflix and Disney+.
Legal issues: Is the company facing any lawsuits or investigations? This could be anything from a customer suing over a faulty product to the government investigating the company for shady business practices. Legal troubles can be costly and can seriously damage a company's reputation.
Debt: Does the company have a lot of debt on its balance sheet? If a company has borrowed a lot of money, it could be at risk if it can't pay it back. This is especially true if the company's revenue takes a hit for some reason.

Industry-specific risks are things that could affect all the companies in a particular industry. For example:

Regulation: Some industries, like healthcare or finance, are heavily regulated by the government. If new laws or regulations come out, it could make it harder or more expensive for companies in that industry to do business.
Technological changes: In some industries, technology moves super fast. If a company isn't able to keep up with the latest tech, it could get left behind. Think about how the rise of smartphones impacted companies that made flip phones.

And then there are the general stock market risks. These apply to pretty much all stocks:

Economic downturns: When the economy is struggling, people tend to spend less money. This can hurt companies' revenues and profits, which can cause their stock prices to drop.
Inflation: If the cost of goods and services goes up too much, it eats into companies' profits. It also means your money doesn't go as far, so you might be less likely to invest.

How do you spot these risks?

A lot of it comes down to doing your research.

1. Read the company's annual report (called a 10-K) and quarterly reports (10-Qs). These will often have a section called "Risk Factors" where the company lays out some of the things that could potentially go wrong. Most companies won't lay this on too thick in case they scare shareholders away.

2. Pay attention to the news. Is the company getting sued? Are there rumors of new regulations coming down the pipeline? These could be red flags.

3. Look at the company's financial statements. Is their debt load increasing? Are their revenues growing, or are they stagnant?

4. And think about the company's size. In general, smaller companies (often called small-cap stocks) tend to be riskier than larger companies (large-cap stocks). They might have more potential for growth, but they also have fewer resources to weather tough times.

Here's an example:

Let's say you're thinking about investing in a small biotech company that's developing a new cancer drug. Some of the risks you might consider:

What if their drug doesn't get approved by the FDA?
What if a bigger pharmaceutical company develops a similar drug and beats it to market?
What if they run out of money before they can get their drug approved and start selling it?
What if there's a recession and investors become less willing to put money into risky biotech stocks?

These are all real risks that could seriously impact the company's stock price.

Now, this doesn't mean you should never invest in risky companies. In fact, some of the biggest rewards (and statistically, the vast majority of losses!) come from taking on some risk. But you want to make sure you understand what those risks are and that you're not putting all your eggs in one basket.

Diversification to mitigate risks

This is where diversification comes in. We get contacted weekly by people who have invested their life savings into one stock only to find things go wrong and they have lost everything. Yes, there will be individuals who talk about how much money they made doing this but that is a 1 in 10,000 chance.

Don't put all your money into one stock, no matter how much you believe in the company.

Spread your investments across different companies, industries, and even asset types (like bonds or real estate). That way, if one of your investments tanks, it won't ruin your whole portfolio.

And remember, risk is personal. What feels super risky to one person might feel totally comfortable to another. It all depends on your financial situation, your goals, and your personal risk tolerance.

So, when you're researching a potential investment, don't just look at the good things. Take a hard look at the risks and weaknesses too. Think critically about what could go wrong and how that might impact your investment. And make sure you're diversifying so that no single risk can sink your whole financial ship.

The first rule of investing is not to lose your money.

Investing is all about balancing risk and reward. The key is to understand the risks you're taking on and to make sure they align with your goals and your personal risk tolerance. So do your homework, think long-term, and don't be afraid to ask tough questions. Your future self (and your future bank account) will thank you!

What Does "Due Diligence" Mean? A Beginners Guide - Article | Crux Investor (2024)